Four is a trend?

By Buttonwood

WHEN do individual pieces of data become a trend? In the past few days, we have seen a surprise 1.3% monthly slump in British factory output, a 1.8% decline in German industrial production, a 1.7% decline in France, and a 1.2% drop in Italy. No one can blame the weather for these numbers, as they did for first-quarter US GDP.

European stocks have been weaker, although a cumulative 2.6% drop is hardly a sign of panic. At heart, the issue is the same as it has been for several years. Markets have been buoyed by the activities of central banks which have kept rates at unprecedentedly low levels and bought assets. This has encouraged a rush into higher-yielding or more risky assets. To some this is justified by a discounted cashflow model; future cashflows are discounted at a lower rate and thus have a higher present value.

The problem is that investors rarely stop to consider why central banks are being so supportive. It is because they worry that economies have been severly weakened by their debt burdens. That suggests a slower growth profile going forward, before one even considers the impact of demographic changes. Indeed, it suggests shorter recoveries and more frequent slowdowns, just as we have seen in Japan. So as well as adjusting the discount rate, one must adjust forecasts for future cashflows as well.

All this has been disguised by the strength of profits, which have held up well, in part because wages have been suppressed and in part because companies have used their cash to buy back equity and thus boost earnings per share. These tricks can only work for a while; in the end, we risk the Marxist outcome that workers cannot afford to buy the goods they produce. The latest US GDP numbers show a fall in first quarter profits.

A wild card is the impact of emerging market growth. For a while during the recession, emerging market strength had some negative effects; by driving up commodity prices, they squeezed consumer wallets in the developed world. Last year, the emerging markets started to slow. But is that slowdown now showing up in European industrial production data? The latest Chinese trade numbers are ambiguous; both exports and imports were weaker than expected but there does seem to be a question over the quality of the data. But it may be significant that Unicredit's global leading indicator, released today, fell to its lowest level in 12 months.

The trend is not yet decisive but investors seem far too complacent.